Quarterly Market Review April 2015

The table below sets out our strategic asset allocation which is where we recommend portfolios are positioned before taking into account where we are in the cycle. We then show our current or tactical recommendation.

– For Capital Preservation portfolios the Australian equity weight has shifted in favour of a larger global allocation. In fixed income we have taken a modest underweight position and allocated towards other assets.

– Income portfolios we have a small skew towards global fixed income as the currency carry and range of options offer the prospect for higher returns compared to the more restrained Australian market.

– Global equity weights have also been increased for Capital Growth portfolios.

We have tempered our expected index returns given that asset class performance has been strong in recent years and that valuations are no longer as compelling. It is important to note that the returns we represent are based on the underlying index, while few investors’ portfolios are aligned to these indexes.

We also include the additional sources of return, specifically franking for Australian equities, hedging for global investments and the possible above index returns that can be achieved in each asset class on a rolling basis. The standard deviation or risk measure is based on history, but given the very low volatility in fixed income in recent data, we have added a small increment on the assumption that changing rate patterns influence the pattern.

The returns are therefore estimated as shown:

Seven years after the first implementation of quantitative easing (or central bank asset purchases) along with low to negative official rates, there is a forthcoming change in pattern. This is likely to require a reconsideration of asset class returns and, implicitly, portfolio construction. Current low rates, for such an extended period and so broadly enacted, have no precedent. The reaction of investment markets, while to date quite rational, may move towards a less certain and therefore volatile path. Before considering the ramifications, it is worthwhile summarising what the consequences of the past few years have been; some self-evident, others possibly less so.

– Interest rates have been anchored, preventing extreme movements, as well as introducing a relatively predictive framework. Central banks have been at pains to guide financial markets on the likely changes to rates in an effort to create certainty and encourage spending and investment.

– Distortions in investment returns and asset prices have been inevitable. Savers feel forced to take on capital risk in order to achieve an adequate return, especially those with income needs. In part this has also engendered the opposite effect, where the perceived risk of loss is high and therefore the need to save even greater amounts have impacted on spending.

– The imperative to deleverage has been reduced. Most countries have taken on more debt when aggregating the sovereign, corporate and household sectors.

– Currency movements are being driven by shifting capital, based on both interest rate differentials as well as economic and political risks.

– Commodity prices have collapsed, indirectly due to interest rates as excess investment was partially supported by low capital costs. This is most obvious in the energy sector where low cost debt has fuelled the large scale development of US assets. In turn there have been clear winners and losers from falling commodity prices which has then fed its way back into interest rate markets. Judging the prospective interaction of these outcomes is now the challenge for investors. In our view, there will be some short term events and trends that may obscure the longer term issues. We suggest portfolios are balanced between these two time horizons.

The economic background to the coming few years is expected to be muted at best. Opinion is coalescing to the view global growth will be well below the past two decades with multiple structural challenges. The big engine rooms of China and global leveraging have come to an end and the demographic bonus has turned to the question of lower workforce participation, yet relatively elevated unemployment. Leverage, in the overall sense of the word, that is, encompassing sovereign, corporate and household liabilities, has remained high. The call for fiscal leniency, for corporates to invest low cost capital and households to spend rather than save, has not found fertile ground.

While this may appear gloomy at first glance, it is rather that previous global growth rates of circa 4% p.a., with hindsight, are unsustainable. Around 3%, however, is achievable, which is a pickup from the 2.5% of 2014. The US is likely to show relatively stable momentum of 2.5%, possibly 3%, over the coming 12 months and Europe is expected to lift to 1.5% from below 1% at present. Similarly, Japan should comfortably get to around 1% compared to the decline in growth last year. Emerging markets paint a mixed outlook with many of the view that China will not get to 7% after posting 7.3% in 2014. Russia, Brazil and the Middle East are likely to see weak conditions, while other predominately Asian economies aggregate to a stable contribution.

Summarising the tailwinds for global economies, lower oil prices are generally a positive given the propensity to consume by beneficiaries outweighs the fall in investment spending. Lower currencies for Europe and Japan are already showing signs of adding to momentum, labour markets are on aggregate improving and infrastructure spending is emerging.

Globally, services are performing relatively well while manufacturing on aggregate is holding its own. There is some comfort in these trends as services tend to be labour intensive with the prospect of better than expected employment growth. Conversely moderate manufacturing growth is likely to handicap productivity, holding back real GDP.

Source: Markit

The problematic areas include investment post the commodity cycle, which was a significant contributor on a global scale. Housing activity appears to be petering, out given the rise in prices in many regions, and the consumer has shown reluctance to spend any incremental wealth.

Risks lie with a further unravelling of the political discontinuity within Europe, a weaker than expected US due to lower investment and China’s incapacity to limit the slowdown in growth. Other issues which may evolve include an upward spike in oil prices, be it due to supply withdrawal or geopolitical instability. Currency movements of recent times have been unusually sharp and it is possible they can revert to some extent later in the year, causing more uncertainty.

Others will point to a potential misstep by the omnipotent central banks, a failure of an economic mechanism or institution, or a disruptive data breach or interference with an essential utility. In our view, these risks are always present, and unpredictable.

The Australian environment is particularly difficult and it is easy to paint a picture of a decade of suboptimal growth. The best prospects lie with a broadly based infrastructure programme and services such as education, tourism and professional services. While at this stage sufficient impetus from such activity may seem improbable, we highlight that other economies, for example, the UK, have in recent years achieved a decent growth rate even allowing for a significant number of imbalances and hurdles.

Low GDP growth, high debt, subdued but possibly erratic inflation and complex interest rates all imply difficult investment conditions. Few can step away from the likely lower returns in all asset classes compared to the past couple of decades. Greater variability is also anticipated. However, the key issue is that cash is most probably going to deliver the lowest return over a 2-3 year time frame. Therefore, while cash makes sense to accommodate movements from asset classes and within them, it is expected to deliver a suboptimal outcome.

In part, the rationale is that the central monetary settings and the lending banks offering cash rates have no incentive to protect the real value of money. Central banks may be comfortable to see debt devalued over time if the cash rate is below the inflation rate and banks can, without demand for credit, price the high level of current saving on the understanding that many do not account for the real loss of value.

The question turns to ways to enhance and protect real capital for investors. While value within investment markets is a tough and largely ambiguous debate, few commentators today shy away from the proposition that both equities and fixed income markets are trading above their historic average, baring a few notable exceptions. In itself this is not a cause for alarm as logically markets are either above or below historic averages. But it does imply that the returns over the coming years can be expected to be lower than the past few years and that periods of negative returns are increasingly likely.

The key in our view is to be selective, flexible and diversified with a greater focus on protecting the downside, even at the expense of foregoing some of the upside.

What can equities offer?

Supporting asset values is the low cost of capital. With higher equity valuations and historically low interest rates, corporates can access both equity and credit markets with relative ease.  Yet the level of mergers and acquisitions has been tempered by investors keen to see excess capital returned through dividends and buybacks. The balance appears to remain in equity investor’s favour with risks of excess payment for acquisitions contained by institutional influence on capital management.

Another related outcome has been revisiting the asset base with an increasing number of companies willing to sell off or demerge operations to the benefit of all. It may be hard to accept that one and one can equal more than two; yet that has been the case as focused management and capital resources have often renewed both parts.

Many corporations have turned to cost reduction to improve earnings. These are often underestimated in extent of scale and timing. In turn this is also where the linkages between economic growth, very much focused on employment, and corporate health, are less certain. Clearly most corporations prefer high levels of employment, yet wage costs are the probable source of cost saving for most companies. In practise the benefits tend to move in cycles; currently the US is expected to show some wage pressure, whereas Europe and Australia are likely to experience greater flexibility.

Disintermediation is a common phenomenon, as new entrants with none of the infrastructure and attitudes set up to serve the past are carried in the asset base and regulation of new businesses. In our view, retail, banking and insurance are examples of sectors experiencing such change. While many may believe this is only within the digital landscape, it is more widespread. Financial services offered outside the existing participants is an example. Retail too has seen more challenges from store participants than online.

The adage of disruptive technology is now so commonplace it may fall on deaf ears. Yet it is not hard to paint a picture of an emerging rather than maturing evolution. 3D printing, data interpretation, integration of social networks and cyber security are all expected to make a much greater impact than we currently expect. There are others; demographic changes, water, energy utilisation, MOOCs in education, to mention a few, that are open to transforming industries and creating options for new or more rarely transformational existing participants. Venture capital will support the emergence of many and for the lucky few offer extraordinary returns. For most, however, the best path is in the listed space, once the commercial aspects are proven and open to challenge.

In the emerging world the best place to get traction is with those willing and able to invest in a ‘middle class’. For those of us in the developed world we should adapt to what that might mean for others. An Australian middle class, with a traditional ‘hills hoist’ view of the world may not be attuned to others where lifestyles are different, yet attitudes to achievement are parallel. Education, services, holidays, health and wellbeing are anchors over and above real estate or motor vehicles, for example. Portfolios with some alignment to the spending pattern of a large component within another ‘middle class’ framework is likely to be rewarding in the longer term.

While we are cautious on the rationale, equities do offer an income yield in line or above other asset classes at this time. Equity returns should be about the judicious use of risk capital. Dividend return is a core of that outcome – here we stress ‘outcome’- rather than a forward measure. In our view, the presumption has turned to equity dividend as a predictive measure, rather than the consequence of good cash flow investments made over time. Yield is critically important, but the sustainability and vulnerability of that yield is where we encourage investors to be conscious of their level of exposure.

We therefore make the case that equities retain their place for growth even with constrained GDP, but, as noted, it is about being selective and prepared to accept that in some cases the thesis does not evolve as envisaged.

In summary we recommend an active rather than participant approach to equities at this time. In some cases it may be hard to realise capital gains, yet relieving portfolios of concentration and historic bias can be critical to success in the next few years. To parlance markets, ‘alpha’ or excess returns over a benchmark is currently outweighed against beta or benchmark participation.

The recommended weighting in equities is prima facie determined by our strategic portfolio asset allocation.

The decision on relative weight is firstly a function of characteristics of respective index and secondly a judgement on the current valuation. In terms of characteristic, Australian equities provide:

– Low cost access with a wide range of mandates and flexibility.

– A number of sectors that exhibit oligopoly like conditions due to the scale advantage of operating in a small economy. Higher and sticky profit margins tend to ensue.

– A high dividend payout which influences a corporation’s capital management. Judiciously used, it can improve returns as equity raising is timed around acquisitions rather than retaining capital potentially over some years.

– Dividend franking, a unique and value add component of Australian equities. Conversely we believe the features noted below make a case against very high weights:

– Familiarity as a rational support for Australian equities, albeit it is a bias few escape. Familiarity does not necessarily improve the investment outcome; rather it can result in over confidence on the merits of a company and the predictability of investment returns.

– The captive flow pool from superannunation does not protect downside risk as was all too evident in 2008/09.

– High payouts can result in periods of significant dilution of returns when leverage rises as corporations replace debt with equity.

Our remarks above should lead to the conclusion that a considered diversification towards global equities is important at this time. Global companies are more likely to benefit from disintermediation and disruption with a much wider range of options for fund managers. They have tended to show greater flexibility in capital management in contrast to Australian equities which are locked into high payout ratios.

We find it useful to remind ourselves of the representative weights of sectors and regions in the commonly used MSCI All Country Index.

Source: MSCI

Source: MSCI

Cumulatively, Europe, ex-UK represents 16%, while all Emerging Markets (EM) are also at16% with China, Korea and Taiwan 50% of EM.

For some time the US market has been the success factor in global performance. Over the last 12 months Europe and Japan have been better markets in local currency terms. Sector contributions have been relatively stable with healthcare and IT on a multi-year winning streak followed by somewhat volatile consumer discretionary and staples.

Based on current data, Emerging Markets and Japan have substantially better valuations than the US and Europe, trading at around 14X FY15 PE versus 18X for the All Country index. After an initial shakeout for EM markets as the oil price fell at the same time as a US rate cycle became clearcut, investors have been more discriminatory between the winners and losers from these trends. EM countries have also cut rates and have been able to ease up on price fixing energy given the lower costs. EM does show a leveraged volatility to global influence yet, for longer term investors, there is more opportunity here than in most other markets.

On the other hand Europe is no longer as undervalued given its recent outperformance, yet the earnings upside from an improvement in growth is still to come, and the indirect support from the ECB for such assets and dividend yield has some way to run. The chart shows the differential between equity and credit markets.

Source: JPMorgan

We maintain the view that a cross section of global fund managers are best positioned to move with the potential returns from a highly diverse set of opportunities. ETFs also play a part due to lower costs, reduce variability relative to the index and easy liquidity, but, as noted, we lean towards active managers at this time.

The benefit of unhedged global holdings has been all too evident in the past year. While the trajectory for the A$ is likely to move at a slower pace, there is still downside given the likely direction of interest rates and growth potential. Nonetheless, we anticipate progressively recommending increased hedging to portfolios over the year.

On most measures, the Australian equity market is a little on the expensive side, with the forward price/earnings ratio now approximately 17x. Few sectors exhibited meaningful top line growth in the most recent reporting season, while cost-out and turnaround stories were common. Dividend payout ratios were generally higher across the market, with strong support from investors for the yield thematic.

The chart below illustrates how the recent market performance has not been driven by underlying earnings growth. Forward earnings estimates have actually been lowered a little over the last few months (primarily the mining and energy sectors), however the market has rallied further in the early part of this year.

Source: Bloomberg

Broadly speaking, the three key drivers of Australian equity returns are interest rates, commodity prices and the $A. Two of these three, being interest rates and the $A, have been behind equity returns over the past year. Lower interest rates have underpinned the market’s returns for some years now, while the $A has been an added tailwind over the last six months following a significant depreciation against the $US.

Of the three, interest rates appear to be the primary driver at present and it is for this reason that we exercise some caution about assuming that the Australian equity market can sustain its returns of the last three years.

When considering the effect of lower interest rates on equities, one can take the ‘glass half full’ approach or, alternatively, the ‘glass half empty’.

The ‘half full’ interpretation would conclude that lower interest rates are a positive for the market. The debt funding cost of companies has reduced, thus increasing the valuations across the market. This valuation impact on highly leveraged sectors, such as infrastructure and utilities, can often be quite material.

The ‘half empty’ lens would say that interest rates are low because economic growth is expected to be lower in the medium term. If this is the case, valuations of equities should naturally be lower, reflecting this lower growth environment.

Investors are at this stage backing the former view. However with interest rates left with far less room to move, it would appear that this source of equity market returns is close to running its course. As we note in our comments on fixed income, an eventual normalisation of interest rates is likely to take time. From an income perspective, the (still) strong yield from equities has relative value to other assets, provides a downside buffer, as well as attracting attention from international investors, particularly now that the $A is now viewed as closer to fair value.

This tailwind of a lower $A should continue to play out for a number of companies in materials, healthcare and select industrials over the following few months, though we highlight that most of these stocks are expensive compared to global counterparts.

Commodity prices have arguably been the main drag on the overall market’s returns over the last few years. After sharp falls in iron ore and gas over the past year, the downside is more limited. Few, however, are predicting a recovery in the well-supplied iron ore market. The prospects for improvement in energy markets appears to be better, although patience will likely be required as the US shale industry adjusts to a lower price environment.

In these comments we refer to concepts such as duration, roll down and credit quality. Please refer to our separate document available on our website which explains these terms.

Australia

Long dated fixed income bonds have been one of the best performing assets in recent months with yields on 10 year government bonds falling to their lowest levels ever.

The rate cycle may not be over yet, with consensus suggesting at least one or two more cuts by the RBA. Capital gains on bonds may be tempered by the expected rise in the US Fed Funds rate later this year. Despite this, the consensus view on domestic rates is that they will remain lower for longer and the pace of increase will be more measured than before. The combination of weak economic growth, scarcity of AAA rated bonds, and regulatory requirements imposed on the banks will weigh on bond yields.

We therefore continue to see value in having exposure to duration within a diversified investment portfolio. Given the scope for rate cuts, fixed income fund managers can take advantage of the roll down effect of bonds on intermediate and longer dated maturity. In addition, long duration bonds should continue to offer stability in times of higher equity volatility.

Our Australian fixed income fund recommendations includes 10-20% long duration strategies. However, we remain mindful of the impact of the Fed moves on interest rates domestically and will reassess our views if our market is overly responsive to US policies.

Credit spreads on high quality Australian fixed income assets have tightened. The ‘search for yield’ following the RBA’s rate cut, amidst an environment of stable corporate profitability, has benefitted investment grade corporates and to a lesser extent supra-nationals. Listed hybrids and subordinated debt have all performed well with demand increasing as investors look down the capital structure to pick up more yield.

At this point, credit portfolios are likely to provide a yield to maturity of around 3.5-4%. In addition, fund managers are able to extract a further 1-1.5% in returns through currency, yield curve positioning, sector rotation and movement up and down the capital structure.  We recommend a high weight to domestic short duration credit portfolios as they provide a higher yielding alternative to term deposits, while less volatile than longer duration strategies.

Global

The divergence in the path of monetary policy between developed economies is a key feature of this year. While the US Fed wavers between a rate hike mid to later this year, the conclusion appears inevitable. Downside risk therefore remains for US bonds despite increased transparency of rate movements by the Fed.

However, the strong dollar, moderating domestic growth as well as slowing Asian economies may temper the rate at which the Fed will raise rates. The short end may be pricing in too much of a rate increase and fund managers that are positioned in the 1-2 year part of the curve should benefit if market participants reduce their bullish views on rates in the front end.

Global credit markets continue to offer value to Australian investors. Low default rates and favourable credit conditions in the US have resulted in spread contraction for both investment grade and risk assets since the beginning of 2015. For example, the US High Yield market has outperformed the Barclays U.S Aggregate Bond Index and the S&P 500 in the first quarter. The currency carry for hedged global funds is significant given the difference in cash rates. If rates fall domestically relative to the US then this currency carry will contract. However additional return will be gained through the new purchases of US assets and floating rate bonds priced at the higher interest rate. In the meantime the carry between the A$ and Euro is likely to be retained.

With market expectations of continuing ECB quantitative easing and government bond purchases for the indefinite future, Portuguese, Italian and Spanish yields are at record lows. However, with little default risk in the peripherals ex-Greece, given the ECB’s role as the buyer of last resort, these sovereigns continue to offer a pick up over their European counterparts and should remain a profitable trade in the short term.

Source: Kapstream

Fund managers have found productive returns from emerging markets when included in a flexible mandate. While countries such as Mexico and Brazil have been negatively impacted by the fall in oil prices and now exhibit elevated volatility despite the global search for yield, other options in Asia come to the fore.

In aggregate our selected global managers maintain around 30-40% traditional fixed income exposure, but our bias is ‘unconstrained’ funds that don’t track the benchmark.

Recent returns for fixed income assets have been extremely favourable, particularly given their low levels of volatility and this is unlikely to be sustained. Returns in the 4-6% range are more realistic with perhaps slightly higher levels of volatility then we have enjoyed over the last couple of years.

Even in this low rate environment, investment opportunities can present themselves to those funds with flexible mandates and we continue to recommend  diversification across fixed income sectors in order to achieve a smooth return profile for this asset class.